Monitoring and Rewarding Performance
The modern firm is built on formal and informal systems of carrots and
sticks to motivate managers and other workers to take actions in the inter-
est of the organization. These include merit evaluations, raises, bonuses,
promotions, lateral transfers, perquisites, admonishments, pats on the back,
and even firings. Here we will focus on formal monetary reward structures
and pose the following question: To what degree can pay-for-performance
mechanisms mitigate moral hazard problems in organizations? In our
answer, we examine two specific problems: motivating workers and maxi-
mizing executive performance.MOTIVATING WORKERS Probably the most pervasive form of principal-
agent relationship is that of employer and worker. For the relationship to
work successfully, the firm (the principal) must motivate the worker (the
agent) to act in the employer’s interests. Workers have knowledge and abili-
ties advantageous to their companies, but they also have their own needs and
desires that may differ from the firm’s objectives. Workers may simply wish to
labor less hard and to enjoy life more, thereby sacrificing potential profits of
the company.
Consider the following simplified model of the employer-worker rela-
tionship. The worker controls the amount of effort he or she puts into the
job. An increased level of effort raises the workers’ output, thereby increas-
ing the company’s profit. However, increased effort generates disutility for
the worker.
Tying compensation to effort is one way to induce higher effort levels. If
both the employer and employee can observe effort, they can design an opti-
mal contract. First, employer and worker should agree to an effort level that
maximizes the net benefit from the employment relationship. This net ben-
efit is just D, where denotes the firm’s profit and D denotes the
worker’s disutility. Suppose, for example, that a second-year associate at a
small law firm works an average of 55 hours per week in return for a $55,000
annual salary. Suppose that the associate generates $80,000 in additional net
revenue for the firm and that the associate experiences a personal disutility
valued at $40,000. Here, the net profit from the employment relationship is
80,000 40,000 $40,000. The firm’s share of this is 80,000 55,000
$25,000, and the associate’s share is $15,000 (the difference between the
actual pay and the least amount he would accept in compensation for the
disutility of the job). Both sides know these facts and know that working
shorter or longer hours would diminish net profits. For instance, working 70
hours a week might generate increased billings and raise profit to $90,000,
but it would also imply a disutility of $60,000, reducing the net benefit to
$30,000. Thus, employer and worker settle on the efficient (55-hour-per-
week) work arrangement.602 Chapter 14 Asymmetric Information and Organizational Designc14AsymmetricInformationandOrganizationalDesign.qxd 9/26/11 11:03 AM Page 602